Who Shall Arbitrate?

Scott Sumner routinely forgets my name when listing people who thought money was tight, and favored unconventional monetary responses to the recession…but that’s okay. I wasn’t blogging that much in late 2008. In any case, I would like to provide a concise answer to a question Scott raises on his blog today:

The very fact that Congress and the President are ignoring this issue (confirming FRB nominations), pretty much tells me that they are clueless on monetary policy. On the other hand, both groups do favor more AD, so their “heart” is in the right place. And of course I’m a big believer in democracy. So who do I favor making the decisions; the clueless or the heartless? I’m tempted to say “Whoever agrees with me; first tell me the target Congress would set.” But of course that’s cheating. The honest answer is that I don’t know. But it is becoming increasingly clear that we won’t get good policy until this dilemma is resolved.

In my mind, the myth of an independent central bank has pretty much been shattered (Karl’s as well). Every time the theory of why we have an independent central bank has been put to the test in a big way, the Fed has failed miserably.

But maybe the answer is more nuanced than that. Perhaps the Federal Reserve itself is simply a proximate cause. If you take the view that the actions of the Fed represent the consensus of the economics profession, then perhaps it is the economics profession who are the underlying cause.

In either case, it is clear that there should be hard rules in place that the Fed must abide by. At the same time, I think that the Fed should have maximum room to act independent of politics when it really needs to. Our current “dual mandate” provides nothing but an excuse for the Fed to shirk its duties. Thus, I believe that the Federal Reserve Charter should be rewritten to state that it is the Fed’s contractual duty to set an explicit nominal target, level targeting, and do everything in their power to hit that target. If you ask me I favor NGDP, but some people favor price level, and some favor inflation…if you really want to pin the Fed down, write which nominal target the Fed needs to hit into the charter. NGDP will still be here 100 years from now.

However, and this is important, that is the end of Congress’ power. Once they have arbitrated as to what the Fed needs to do, Congress gets out of the way and lets the Fed act. The only point at which Congress should have the authority to intervene is if the Fed is off-target, in which case Congress should have the power to remove the current board (or specific members) and appoint a new one. But, and this should be written into the charter as well, the only circumstances in which Congress can do so is if the Fed is missing its target (or criminal behavior, or other things that don’t have to do with monetary policymaking).

Separating politics from policymaking is definitely a good thing (I even came around on TARP), especially in monetary policymaking. However, having a monetary authority that is gallivanting around, allowing NGDP expectations to plummet 8% with zero recourse is unacceptable.

Even that isn’t foolproof. We have the system closest to that here in NZ. The Reserve Bank Act says that the RBNZ is independent and only needs to do what the Policy Targets Agreement says: one goal, an inflation range of 1-3%. But that has to be achieved only over the medium term, and nobody defines what the medium term is. Around 2005-6 we had about 5 quarters’ inflation above the top of the band while the Governor seemed to be targeting the top rather than the middle of the band, or experimenting with whether the growth rate could be kept up without inflationary consequences. The Finance Minister and Governor seemed to be winking at each other about whether the RBNZ’s actions were consistent with the Policy Targets Agreement.

On the plus side for RBNZ, their macro model is called “Kiwi Inflation Targeting Technology”, or KITT. That’s right – KITT is running our inflation targeting. They have a Turbo-Liquidity-Boost button somewhere in there, I’m sure….

Sorry for the oversight, I just added your name to the “Soul-Searching” list. Now you have to tell me if you are a left-winger, as that would weaken the argument I make in that post.

My only excuse is that I have a terrible memory for names. I’ve seen your blog before, but wasn’t following it much in early 2009. Or maybe I did but forgot.

In any case, I mostly agree with what you wrote here. But there was a semi-respectable argument that independent central banks did slightly better during the Great Inflation. Still, I agree with your argument that we need to pin them down with a explicit target.

I think that we probably approach the issue differently. There of course are various differing opinions about what the “ideal target” is. For example, Woolsey prefers a 3% nominal spending target as defined by final sales of GDP…which isn’t too much different than an NGDP target.

I don’t favor a long run inflation target for a couple reasons. First, there are wildly different deflators out there that would produce wildly different assessments of inflation. There is no shortage of people who know what the “real rate of inflation” is, and always claim that the government is understating. Second, having a strict inflation target biases monetary policy toward accelerating bubbles in a way that a simple NGDP target does not. For example, what if there is an incredible productivity shock that pushes the inflation rate down while the real growth rate remains stable…well, the Fed needs to increase inflation to meet its target, blowing up asset bubbles in the process. Some form of this was seen in the late 90′s/early 00′s. Of course, pure inflation targeting has a problem even with temporary AS shocks (a shift of SRAS to the left). Inflation would increase, and thus cause the Fed to tighten policy to bring inflation back in line with the target — further weakening an economy that is entering recession territory.

Don’t get me wrong though, I would be fully behind any sort of explicit inflation target right now!

As to your worries about whether the central bank can hit a target like NGDP, I think that you’d be hard pressed to find a central bank that couldn’t produce inflation — even in the presence of a broken banking system. The problem that I have with mandating a “full employment” target is that full employment is a real, tangible thing. If the unemployment rate is 10%, that is 50 million real people not working, whereas an NGDP target is simply numbers in a computer. If the chips were down, and the Fed was really hard-pressed to hit a target, it could simply print up however much money it needed and give it to the government to spend.

The virtue of level targeting is that the Fed would set medium or long-run target for GDP based on the average level of output over some period of time (which has been ~5% throughout the Great Moderation (or Complacency?), and then extrapolate that trend out into the indefinite future. The day-to-day operations of the FRB would be to see to it that the mid-/long-run forecast was on target within a reasonable error band. If we are under-target, than we have a period where we get some extra inflation (or, rather, given a flat SRAS, we get extra output). If we are over-target, then we get a period of under-inflation.